Transcript Document

Week 7
Presentation is from:
Class notes of Prof. Gerald Shively
Purdue University
(AGEC 640: Agricultural Development and Policy)
Market Equilibrium and Social Welfare
Slide 2
Market equilibrium with trade & policy
The story so far…
Up to now we’ve taken prices as given, asking how
households respond with substitution in production:
Qty. of corn
(bu/acre)
Qty. of corn
(bu/acre)
Pl/Pc Pl/Pc’
more corn,
more input use
Qty. of labor
(hours/acre)
Pb/Pc’
Pb/Pc
more corn,
less other outputs
Qty. of beans
(bushels/acre)
Each price change
affects the
household’s
production choices,
input use
and income
Slide 3
…and on the consumption side:
Households respond to price changes with
both income and substitution effects:
Qty. of
corn
substitution
effect
income
effect
Each price change
affects the household’s
production choices,
input use and income
The household’s
total income and
expenditure at Po/Pc’
The household’s
total income and
expenditure at Po/Pc
Qty. of all other goods
Slide 4
Adding up production decisions across households
gives us an aggregate supply curve:
Price
($/lb)
each producer’s production is added horizontally
each price is every
participating household’s
marginal cost of production,
in terms of other goods
…but remember at each price
some households are not trading!
Quantity Produced
(thousands of tons/yr)
Slide 5
…and adding up households’ consumption decisions
gives us an aggregate demand curve:
Price
($/lb)
each consumer’s demand is added horizontally
each price is every participating
household’s willingness
and ability to pay
…but again at each price
some households are not trading!
Quantity Consumed
(thousands of tons/yr)
Slide 6
…so the aggregate of all households’
production costs and willingness-to-pay is:
P($/lb)
MC
WTP
Q(tons)
So, what price are we likely to observe in the market?
…almost all interesting cases have
something else we’d need to draw!
Slide 7
What price would we observe if these people
can trade with the rest of the world?
P($/lb)
MC
WTP
Q(tons)
We need to draw a similar diagram for them,
and for the trade between us and them
“Us” (e.g. Turkey.)
P($/ton)
Q(tons)
Trade between
The Rest of the
us & them
World (RoW)
P($/ton)
Starting with foreign supply and demand:
Trade between
Turkey and the The Rest of the World
world P($/ton)
Turkey
P($/ton)
Q(tons)
Note we’ve drawn the same price axis for
Turkey and RoW (ignoring exchange rates)
Then we can draw Turkey’s
willingness to trade with the RoW:
Turkey
P($/ton)
Trade between
Turkey and RoW
The Rest of the World
P($/ton)
ED
Q(tons)
Q(tons)
The Turkey’s “excess demand curve” in trade, i.e. the amount
demanded at any price that cannot be met by domestic supply.
and RoW’s willingness to trade…
Trade between
Turkey and
The Rest of the World
ROW P($/ton)
Turkey
P($/ton)
ES
ED
Q(tons)
Q(tons)
Q(thou. tons)
The “excess supply curve” in trade shows the amount supplied by
the world at any price that exceeds the world price.
World Price Clearing…
Trade between
Turkey and
The Rest of the World
ROW P($/lb)
Turkey
P($/lb)
ES
ED
Q(tons)
Q(tons)
Q(1000 tons)
Because total quantity in the RoW is large, the “excess supply” curve is
almost flat when graphed on the same axis as Turkey’s curves.
International markets clear when ED=ED
The large size of the rest of the world allows
us to simplify the diagram
Trade between
us and them
The Rest of the World
P($/ton)
Turkey
P($/ton)
ES
ED
Q(tons)
Q(tons)
Q(thou. tons)
the simplifying assumption that
this line is horizontal is called
the “small country” assumption.
Slide 14
The small-country assumption allows a single
diagram to both Turkey & the RoW
Trade
between
The Rest of the World
Turkey P($/lb)
Turkey
P($/ton)
ES
ED
Pw
Q(tons)
Q(tons)
Q(thou. tons)
As the “world” price would not
be affected by changes in Turkey.
Slide 15
For many important traded products, prices are
determined by the world’s supply-demand balance,
not local production and consumption.
Turkey
P($/ton)
Pw
Q(tons)
Local supply and demand determine production, consumption
and trade, at a price given by the big (bad?) world market
Slide 16
But then there’s policy!
Policies on imports
Policies that
help producers
raise Pd
above Pt
import
tariffs
or
quotas
Policies that
import
help consumers subsidies
lower Pd
(rarely
seen)
below Pt
Policies on exports
export
subsidies
export
taxes or
quotas
Policies that work through trade
affect both producers and consumers.
Slide 17
But what about “domestic” policies?
Policies that tax production affect a market like this:
S’ (market supply, after taxes)
tax
S (producers’ marginal cost)
and policies that tax consumption look like this:
D (consumers’ demand)
tax
D’ (market demand, after taxes)
Taxes restrict the market supply or demand, shifting them to the left…
Slide 18
Policies that subsidize production work like this:
S (producers’ marginal cost)
subsidy
S’ (market supply, after taxes)
and policies that subsidize consumption work like this:
D’ (market demand, after subsidies)
subsidy
D (consumers’ demand)
Subsidies expand market supply or demand -- shift curves to the right.
Slide 19
Combining these concepts, we have six possible
policies in markets for importables
on trade
on production
on consumption
taxes
or
restrictions
subsidies
or
encouragements
affect both
prod. & cons.
affect only
production
affect only
consumption
Slide 20
…and six possible policies in markets for exportables:
on trade
on production
on consumption
taxes
or
restrictions
subsidies
or
encouragements
affect both
prod. & cons.
affect only
production
affect only
consumption
Slide 21
Can we say anything about “social welfare”?
• What can we infer from the diagrams about how price changes
affect consumer or producer welfare?
• What can we infer about net effects on “social” welfare?
• The simplest and most widely used approach is to compute
changes in aggregate “economic surplus”:
– areas on a supply-demand diagram
– measured in terms of money (=price X quantity)
– but equally relevant in a non-monetized setting…
• To see strengths and limitations of econ surplus approach we
should start with fundamentals
Slide 22
Criteria:
How could we evaluate a change?
as qty. rises, the gap
between the curves falls…
until this marginal
economic surplus
reaches zero at the
equilibrium
Pobs.
Qobs.
“Economic surplus” is simply
the area between S & D curves
Pobs.
The Hines article
explains how this area
came to be the workhorse
definition of “social welfare”
in applied policy work, despite
its limitations relative to other
definitions of social welfare.
Qobs.
There is a very close link between
“positive” economics (for prediction)
and “normative” economics (for evaluation)
For example, if new
technology reduces
marginal cost by 10%,
we can predict that
the new P’ will be lower and
the new Q’ will be higher.
A lower price means producers
may lose…
but the logic of economic
surplus means there must be a
net gain to society as a whole.
Pobs.
P’
Qobs. Q’
Equilibrium = Optimum ?!
Pobs.
If the equilibrium is the social
optimum, do we live in the
best of all possible worlds?
If you have no other information,
you cannot say something else
would be better!
Qobs.
Econ 101 vs. Econ 102
Pobs.
To continue the analysis, we
need to know something about
some other costs and benefits
incurred in this market.
Qobs.
• The question for welfare economics is, what can one infer
about “aggregate welfare” from individual choices, which
are assumed to be optimizing an unknown utility function.
• The answer is…
not much…
unless we make additional, quite strong assumptions
e.g. all consumers are similar in certain ways,
or face prices that are similar in certain ways
“Welfare economics” is about those assumptions and
their effects. Most are not testable…
Slide 28
… we should remember…
• The Pareto Principle
– A “Pareto improvement” is preferred by at least one person, and
dispreferred by no one.
– Very many situations are already “Pareto optimal”, and
designing Pareto-improving policies is very difficult!
• The “first theorem” of welfare economics
– A perfectly competitive equilibrium would be Pareto optimal
(because everyone faces identical prices)
• The “second theorem” of welfare economics
– Any P. optimum can be reached by a p.c.e. with transfers
(but only if everyone can use the transfers to adjust consumption!)
Slide 29
…and, more practically,
the Compensation Principle
• Is “Pareto improvement” needed for a change to be good?
– what if many gain, and only one person loses?
– what if the gains are much larger than the losses?
– would the gains have to be redistributed immediately for the
change to be socially desirable?
• Usually, we invoke the “compensation principle”:
– we use the term “Pareto improvement” loosely, to mean a
potentially Pareto-improving change, whose gainers could (but
don’t necessarily) compensate losers and still be better off.
– Income and wealth is constantly being (re)distributed through
various mechanisms; this way we separate the questions, and do
not expect changes to generate gains and also redistribute them!
• In real life, “reform packages” often involve some
compensation, to those who could block the change.
Slide 30
Arnold Harberger and
the Triumph of Economic Surplus
• Harberger’s three postulates (untestable!):
– marginal willingness to pay is value in consumption
– marginal supply price is cost of production
– economists should be impartial, and count everyone’s
money equally.
• Surprisingly, this turns out to lead towards political
positions that are often quite “liberal”,
– because actual politics often involves “King John
redistribution” (from poorer to richer people) and “vested
interests” (that block pro-poor changes).
• A major determinant of economic growth is the
extent to which governments follow Harberger…
Slide 31
Economic surplus treats the market as a household
highest indifference level
in a household model
Qty. of
“a” goods
Qa
highest economic surplus
in a market model
Price of
“b” goods
slope of indiff. curve
 Qa
 MRS 
Qb
equilibrium
among
optimizing
people in a
perfectly
competitive
market
Pb
slope of income
line =-Pb/Pa
Qb
Qty of “b”
Qb
Slide 32
We can divide “economic surplus” into:
Price of
“b” goods
“Consumer surplus” :
area between price paid
and the demand curve
Pb
“Producer surplus” :
area between price received
and the supply curve
The sum of everyone’s gains/losses
is society’s total economic surplus
Qb
Slide 33
Trade creates a distinction between production
and consumption – e.g. when we start selling:
Producer surplus in “b” declines by:
Qty. of “a”
goods
…but consumer surplus
in “b” rises by:
Net gain from trade
Price of
“b” goods
Increase in
consumption
of “b”
Decline in
production of “b”
Qty of “b”
A
A B
==> net social gain
from trade in “b” is:
B
A B
Qty of “b”
Slide 34
New technologies also have very different
impacts on producers and consumers
Price of
“b” goods
Consumer Surplus Gain = A+B
Producer Surplus Change = C-A
Net Econ. Surplus Gain = B+C
A
B
C
If demand is very inelastic, and
supply is very elastic, then
innovation causes producer
surplus to fall.
This is “Cochran’s Treadmill”,
pushing ag. producers to
Qty of “b” become ag. consumers.
Slide 35
…but note that if a good is traded at a fixed price…
innovation does not affect consumers;
all gains go to producers!
Price of
“b” goods
With no trade
Price of
“b” goods
No innovation
With innovation
Qty of “b”
With free trade
No innovation
With innovation
Qty of “b”
Slide 36
So what do we see, and why do we see it?
The incidence of each policy is price change X qty. affected,
or economic surplus – a useful measure of welfare change
For example, the U.S. market for avocadoes
P($/lb)
Policy is an import quota (M)
Pus
Pw
A
B C
D
Consumers lose ABCD
Producers gain A
Who gains C?
Qp Qp M Qc Qc
In this case, avocado growers’ associations were given import quotas,
and so captured the “quota rent” C from buying at Pw and selling at
Slide 37
Pus, as well as the increased producer surplus A.
Areas B and D are Harberger triangles,
permanent losses to domestic economy.
Turkey
P($/lb)
Pus
Pw
A
B C
Production efficiency losses,
where MC is above Pw
D
Consumption efficiency losses,
where WTP is above Pw
Slide 38
Comparing instruments across markets
An import quota instrument (M’)
S
Pus
Pw
A
B C D
QpQp’
Qc’Qc
C.S. change: -ABCD
P.S. change: +A
quota rent:
+C
net change: -B D
An import tariff instrument (t)
S+quota
Pw+t
Pus
Pw
A
B C
D
Qp Qp’ Qc’Qc
C.S. change: -ABCD
P.S. change: +A
tariff revenue: +C
net change: -B D
Note that this “tariff-quota equivalence” is limited; if there are
Slide 39
changes in S, D or Pw, the two policies lead to different responses!
What about policy on exports:
If trade is good, surely more trade is better?
Pdom
an export subsidy:
Ptrade
A BC D
Qd’ Qd
Remember it’s not trade
as such, but free trade
that’s desirable
(at least in this model)
E
F
Qs Qs’
CS loss:
area AB
PS gain:
area ABCDE
Subsidy cost: area BCDEF
Net loss:
area BF
Slide 40
Some conclusions on market equilibrium
and social welfare
• Different market structures will lead to different equilibrium outcomes
– To the extent that buyers or sellers don’t trust each other, quantity sold would go
to zero -- unless remedied by trust in a brand or third-party certification
– To the extent that buyers or sellers are protected from competition by barriers to
entry, they won’t act competitively -- won’t be “price takers”
• Different definitions of “welfare” lead to different policy preferences
• For policy analysis in this class we assume:
– that equilibria are perfectly competitive
– that “social welfare” is proportional to economic surplus
These are the simple but powerful techniques, that give us many
non-obvious and yet useful results.
Slide 41